Recent update on Sanctions Clause judgment

While sanctions clauses have been frequently included in trade finance instruments, the way as to the apportion of risks materializing from such clauses remains a complex question. The recent Singapore court ruling demonstrated that the interpretation of sanctions clauses in trade finance instrument is under strict scrutiny by court and it may pose challenges for a financial institution to fully offload the sanctions risk onto its client.

In our previous article titled Letter of Credit Sanctions Clause: How to Properly Handle? (available here), we analyzed the High Court ruling of the Singaporean case Kuvera Resources Pte Ltd v JPMorgan Chase Bank, NA [2022] SGHC 213. It was held in the case that the sanctions clause was valid and enforceable, entitling the confirming bank to decline payment under the Letter of Credit to avoid violating U.S. sanctions.

Nonetheless, the Singaporean court of appeal overturned the High Court’s decision (Kuvera Resources Pte Ltd v JPMorgan Chase Bank, NA [2023] SGCA 28) and ruled that the confirming bank was not able to invoke the sanctions clause to decline payment. This new ruling shed light on the limitation of sanctions clauses, and the need for financial institutions to exercise extra care when handling sanctions issue in the context of trade finance instruments.

Background    

To summarise the fact of the Singaporean case, Kureva Resources Pte Ltd. was the beneficiary of two letters of credits (“LCs”). JPMorgan Chase Bank, N.A., Singapore Branch (“JPMorgan”) advised on both LCs and added its confirmations (“Confirmations”) to the LCs to act as the confirming bank for the LCs.

The Confirmations contained a sanctions clause which stated that:

“[JPMorgan] must comply with all sanctions, embargo and other laws and regulations of the U.S. and of other applicable jurisdictions to the extent they do not conflict with such U.S. laws and regulations (“applicable restrictions”). Should documents be presented involving any country, entity, vessel or individual listed in or otherwise subject to any applicable restriction, we shall not be liable for any delay or failure to pay, process or return such documents or for any related disclosure of information.” (“the Sanctions Clause”)

Kuvera subsequently presented complying documents to JPMorgan, which were subject to JPMorgan’s screening. The issue relates to the carrying vessel, Omnia. Omnia was on JPMorgan’s internal list (“Master List”), which contains the names of entities and vessels that the bank determined had known sanctions nexus. However, Omnia was not on the list of The Office of Foreign Assets Control (“OFAC”). JPMorgan argued that where there was an unresolved possibility that Omnia may be caught under “any applicable restriction”, the Sanctions Clause would entitle JPMorgan to err on the side of caution to decline payment.

It is noteworthy that subsequently, JPMorgan had engaged in correspondence with OFAC and obtained OFAC’s written confirmation as follows to support its decision to refuse payment:

“Had [JPMorgan] and its Singapore branch not rejected the trade documents for a non-U.S. person’s sale of cargo shipped via a Syrian vessel, it would have resulted in an apparent violation of OFAC regulations.”

The strict interpretation of sanctions clause    

The Court of Appeal recognised the incorporation and validity of the Sanctions Clause into the LCs, and accepted the contractual position that US sanctions law is applicable in the case.

However, the Court of Appeal did not agree that JPMorgan’s “risk-based” approach (though rational from management perspective) is the correct interpretation of the Sanctions Clause. The court was of the opinion that:

1. The effect of the Sanctions Clause on JPMorgan’s irrevocable obligation to pay under the Confirmations must be construed strictly.
2. The burden of proof is on JPMorgan and the standard of proof is “on balance of probabilities”.
3. JP Morgan is required to prove on an objective basis that the beneficial ownership of the vessel is Syrian (which is the basis for payment refusal based on US sanctions). The ownership should be determined objectively without third-party input, even from entity such as OFAC.

Applying the above principles, notwithstanding the presence of “red flags” gathered by JPMorgan, JPMorgan has not provided adequate proof to discharge its burden to invoke the Sanctions Clause for justifying the payment refusal. Its due diligence to the beneficial ownership of the vessel, which is based on its own risk taking calculus, was “inconclusive”. JPMorgan lost on the appeal.

Is the Sanctions Clause fundamentally inconsistent with the commercial purpose of the confirmations or documentary credit transactions?    

Though not forming part of the ruling, the court commented that sanctions clauses that are fundamentally inconsistent with the commercial purpose of the letter of credit would not meet the requisite threshold and would be considered invalid, and a sanctions clause that can be invoked to deny payment simply on the basis of arbitrary or speculative element would impede this commercial purpose and create significant uncertainty.

There are a number of English cases recognising sanctions clauses in commercial transactions. However, none of them dealt with rules such as the UCP600 or documentary credit transactions. By nature, documentary credit transactions are unique in that one autonomous contract within the transaction has the effect of securing the payment promised under another autonomous contract, so the court said, it would be slow to place reliance on those English cases.

The court's determination to strictly construe any sanction clauses in documentary credit transactions, and its readiness to strike it out if it impugns the commercial purpose, is clearly indicated by this important remark.

What does this mean for financial institutions?    

1. Given the latest case law, should financial institutions still include sanctions clauses in documentary credits transactions?
   
   The answer is definitely yes. Our view remains that financial institutions should include sanctions clauses in documentary credit transactions.
    
2. How broad should a sanction clause be to protect the financial institutions’ interests without jeopardising its enforceability?
   
   Legal advice should be sought on the appropriate drafting and incorporation of sanctions clauses. As a general principle, a properly drafted sanctions clause should cover the following elements:
   
   o    it should cover the entire bank group
   o    it should be specific enough as to the applicable sanctions regime and to the extent possible, specifically identifying all the applicable law and sanctions authorities, e.g. US law, OFAC, Hong Kong Monetary Authority etc.
   o    it should not refer to any internal guidelines or give the financial institution any discretion to invoke sanctions based on arbitrary or speculative judgment
   
   The last point is particularly important - a sanctions clause that is drafted too broad or subjective will risk falling foul of the requirement of compatibility with the commercial purpose of a letter of credit.
    
3. What should the financial institutions do in case of “red flag”?
   
   To trigger defense by invoking sanctions clauses, mere red-flags or subjective circumstantial evidence is insufficient. An objective list, specifically a publicly available list issued by authorities such as the OFAC (as opposed to an internal list) may be required as supporting evidence. The burden of proof is on the financial institution to show that the sanctions applies to the circumstances at hand.
   
   Therefore, in case a ‘red flag’ is not supported by any publicly available list or information issued by the sanctions authority, financial institutions may consider seeking legal advice to ascertain whether sufficient evidence is present to discharge their burden of proof to invoke the contractual sanctions clauses.

In conclusion, we believe that the inclusion of sanctions clauses remains a vital and preferable method to manage sanctions risk. However, in view of this recent court case, additional caution and procedures are needed when a financial institution needs to invoke the sanctions clause as a defence against its payment obligation.

This information is for guidance purposes only and should not be regarded as a substitute for taking legal advice. Please refer to thefull terms and conditions on our website.